How Strong Is Business Investment, Really?

DeLong rises to defend Ben Bernanke, against claims that unconventional monetary policy in recent years has discouraged businesses from investing. Business investment is doing just fine, he says:

As I see it, the Fed’s open-market operations have produced more spending–hence higher capacity utilization–and lower interest rates–has more advantageous costs of finance–and we are supposed to believe that its policies “have hurt business investment”?!?! … As I have said before and say again, weakness in overall investment is 100% due to weakness in housing investment. Is there an argument here that QE has reduced housing investment? No. Is nonresidential fixed investment below where one would expect it to be given that the overall recovery has been disappointing and capacity utilization is not high?

As evidence, DeLong points to the fact that nonresidential investment as a share of GDP is back where it was at the last two business cycle peaks.

As it happens, I agree with DeLong that it’s hard to make a convincing case that unconventional monetary policy is holding back business investment. Arguments about the awfulness of low interest rates seem more political or ideological, based on the real or imagined interests of interest-receivers than any identifiable economic analysis. But there’s a danger of overselling the opposite case.

It is certainly true that, as a share of potential GDP, nonresidential investment is not low by historical standards. But is this the right measure to be looking at? I think not, for a couple of reasons, one relatively minor and one major. The minor reason is that the recent redefinition of investment by the BEA to include various IP spending makes historical comparisons problematic. If we define investment as the BEA did until 2013, and as businesses still do under GAAP accounting standards, the investment share of GDP remains quite low compared to previous expansions. The major reason is that it’s misleading to evaluate investment relative to (actual or potential GDP), since weak investment will itself lead to slower GDP growth. [1]

On the first point: In 2013, the BEA redefined investment to include a variety of IP-related spending, including the commercial development of movies, books, music, etc. as well as research and development. We can debate whether, conceptually, Sony making Steve Jobs is the same kind of thing as Steve Jobs and his crew making the iPhone. But it’s important to realize that the apparent strength of investment spending in recent expansions is more about the former kind of activity than the latter.  [2] More relevant for present purposes, since this kind of spending was not counted as investment — or even broken out separately, in many cases — prior to 2013, the older data are contemporary imputations. We should be skeptical of comparing today’s investment-cum-IP-and-R&D to the levels of 10 or 20 years ago, since 10 or 20 years ago it wasn’t even being measured. This means that historical comparisons are considerably more treacherous than usual. And if you count just traditional (GAAP) investment, or even traditional investment plus R&D, then investment has not, in fact, returned to its 2007 share of GDP, and remains well below long-run average levels. [3]

investment

More importantly, using potential GDP as the yardstick is misleading because potential GDP is calculated simply as a trend of actual GDP, with a heavier weight on more recent observations. By construction, it is impossible for actual GDP to remain below potential for an extended period. So the fact that the current recovery is weak by historical standards automatically pulls down potential GDP, and makes the relative performance of investment look good.

We usually think that investment spending the single most important factor in business-cycle fluctuations. If weak investment growth results in a lower overall level of economic activity, investment as a share of GDP will look higher. Conversely, an investment boom that leads to rapid growth of the economy may not show up as an especially high investment share of GDP. So to get a clear sense of the performance of business investment, its better to look at the real growth of investment spending over a full business cycle, measured in inflation-adjusted dollars, not in percent of GDP. And when we do this, we see that the investment performance of the most recent cycle is the weakest on record — even using the BEA’s newer, more generous definition of investment.

investmentcycles_broad
Real investment growth, BEA definition

The figure above shows the cumulative change in real investment spending since the previous business-cycle peak, using the current (broad) BEA definition. The next figure shows the same thing, but for the older, narrower GAAP definition. Data for both figures is taken from the aggregates published by the BEA, so it includes closely held corporations as well as publicly-traded ones. As the figures show, the most recent cycle is a clear outlier, both for the depth and duration of the fall in investment during the downturn itself, and even more for the slowness of the subsequent recovery.

investmentcycles_narrow
Real investment growth, plant and equipment only

Even using the BEA’s more generous definition, it took over 5 years for inflation-adjusted investment spending to recover its previous peak. (By the narrower GAAP definition, it took six years.) Five years after the average postwar business cycle peak, BEA investment spending had already risen 20 percent in real terms. As of the second quarter of 2015 — seven-and-a-half years after the most recent peak, and six years into the recovery — broad investment spending was up only 10 percent from its previous peak. (GAAP investment spending was up just 8.5 percent.) In the four previous postwar recoveries that lasted this long, real investment spending was up 63, 24, 56, and 21 percent respectively. So the current cycle has had less than half the investment growth of the weakest previous cycle. And it’s worth noting that the next two weakest investment performances of the ten postwar cycles came in the 1980s and the 2000s. In recent years, only the tech-boom period of the 1990s has matched the consistent investment growth of the 1950s, 1960s and 1970s.

So I don’t think it’s time to hang the “Mission Accomplished” banner up on Maiden Lane quite yet.

As DeLong says, it’s not surprising that business investment is weak given how far output is below trend. But the whole point of monetary policy is to stabilize output. For monetary policy to work, it needs to able to reliably offset lower than normal spending in other areas with stronger than normal investment spending. If after six years of extraordinarily stimulative monetary policy (and extraordinarily high corporate profits), business investment is just “where one would expect given that the overall recovery has been disappointing,” that’s a sign of failure, not success.

 

[1] Another minor issue, which I can’t discuss now, is DeLong’s choice to compare “real” (inflation-adjusted) spending to “real” GDP, rather than the more usual ratio of nominal values. Since the price index for investment goods consistent rises more slowly than the index for GDP as a whole, this makes current investment spending look higher relative to past investment spending.

[2] This IP spending is not generally counted as investment in the GAAP accounting rules followed by private businesses. As I’ve mentioned before, it’s problematic that national accounts diverge from private accounts this way. It seems to be part of a troubling trend of national accounts being colonized by economic theory.

[3] R&D spending is at least reported in financial statements, though I’m not sure how consistently. But with the other new types of IP investment — which account for the majority of it — the BEA has invented a category that doesn’t exist in business accounts at all. So the historical numbers must involve more than usual amount degree of guesswork.

Interest Rates and Bank Spreads

So the Fed decided not to raise rates this weeks. And as you’ve probably seen, this provoked an angry response from representatives of financial institutions. The owners and managers of money have been demanding higher interest rates for years now, and were clearly hoping that this week they’d finally start getting them.

As Paul Krugman points out, it’s not immediately obvious why money-owners are so hostile to low rates:

I’ve tried to understand demands that rates go up despite the absence of inflation pressure in terms of broad class interests. And the trouble is that it’s not at all clear where these interests lie. The wealthy get a lot of interest income, which means that they are hurt by low rates; but they also own a lot of assets, whose prices go up when monetary policy is easy. You can try to figure out the net effect, but what matters for the politics is perception, and that’s surely murky.

But, he has a theory:

What we should be doing …  is focusing not on broad classes but on very specific business interests. … Commercial bankers really dislike a very low interest rate environment, because it’s hard for them to make profits: there’s a lower bound on the interest rates they can offer, and if lending rates are low that compresses their spread. So bankers keep demanding higher rates, and inventing stories about why that would make sense despite low inflation.

I certainly agree with Krugman that in thinking about the politics of monetary policy, we should pay attention to the narrow sectoral interests of the banks as well as the broader interests of the owning class. But I’m not sure this particular story makes sense. What he’s suggesting is that the interest rate on bank lending is more strongly affected by monetary policy than is the interest rate on bank liabilities, so that bank spreads are systematically wider at high rates than at low ones.

This story might have made sense in the 1950s and 1960s, when bank liabilities consisted mostly of transactions deposits that paid no interest. But today, non-interest bearing deposits compose less than a quarter of commercial bank liabilities. Meanwhile, bank liabilities are much shorter-term than their assets (that’s sort of what it means to be a bank) so the interest rates on their remaining liabilities tend to move more closely with the policy rate than the interest rates on their assets. So it’s not at all obvious that bank spreads should be narrower when rates are low; if anything, we might expect them to be wider.

Luckily, this is a question we can address with data. Historically, have higher interest rates been associated with a wider spread for commercial banks, or a narrower one? Or have interest rate changes left bank spreads unchanged? To answer this, I looked at total interest income and total interest payments for commercial banks, both normalized by total assets. These are reported in a convenient form, along with lots of other data on commercial banks, in the FDIC’s Historical Statistics on Banking.

The first figure here shows annual interest payments and interest costs for commercial banks on the vertical axis, and the Federal funds rate on the horizontal axis. It’s annual data, 1955 through 2014. The gap between the blue and red points is a measure of the profitability of bank loans that year. [1] The blue and red lines are OLS regression lines.

Fig. 1: Commercial Bank Interest Paid and Received, as a Share of Assets, and the Federal Funds Rate

If Krugman’s theory were correct, the gap between the blue and red lines should be wider on the right, when interest rates are high, and narrower on the left, when they’re low. But in fact, the lines are almost exactly parallel. The gap between banks’ interest earnings and their funding costs is always close to 3 percent of assets, whether the overall level of rates is high or low. The theory that bank lending is systematically less profitable in a low-interest environment does not seem consistent with the historical evidence. So it’s not obvious why commercial banks should care about the overall level of interest rates one way or the other.

Here’s another way of looking at the same thing. Now we have interest received by commercial banks on the vertical axis, and interest paid on the horizontal axis. Again, both are scaled by total bank assets. To keep it legible, I’ve limited it to the years 1985-2014; anyway the earlier years are probably less relevant for today’s banking system. The diagonal line shows the average spread between the lending rate and the funding rate for this period. So points above the line are years when bank loans are unusually profitable, and points below are years when loans are less profitable than usual.

commbank2
Fig 2: Commercial Bank Interest Paid and Received, as a Percent of Assets

Here again, we see that there is no systematic relationship between the level of interest rates and the profitability of bank loans. Over the whole range of interest rates, spreads are clustered close to the diagonal. What we do see, though, is that the recent period of low interest rates has seen a steady narrowing of bank spreads. Since 2010, the average interest rate received by commercial banks has fallen by one full percentage point, while their average funding cost has fallen by a bit under half a point.

On the face of it, this might seem to support Krugman’s theory. But I don’t think it’s actually telling us anything about the effects of low interest rates as such. Rather, it reflects the fact that bank borrowing is much shorter term than bank lending. So a sustained fall in interest rates will always first widen bank spreads, and then narrow them again as lending rates catch up with funding costs. And in fact, the recent decline in bank spreads has simply brought them back to where they were in 2007. (Or in 1967, for that matter.) No doubt there are still a few long-term loans from the high-rate period that have not been refinanced and are still sitting profitably on banks’ books; but after seven years of ZIRP there can’t be very many. There’s no reason to think that continued low rates will continue to narrow bank spreads, or that higher rates will improve them. On the contrary, an increase in rates would almost certainly reduce lending profits initially, since banks’ funding rates will rise more quickly than their lending rates.

Now, on both substantive and statistical grounds, we might prefer to look at changes rather than levels. So the next two figures are the same as the previous ones, but using the year over year change rather than absolute level of interest rates. In the first graph, years with the blue above the red are years of widening spreads, while red above blue indicates narrowing spreads. In the second graph, the diagonal line indicates an equal change in bank lending and funding rates; points above the line are years of widening spreads, and points below the line are years of narrowing spreads. Again, I’ve limited it to 1985-2014.

Fig. 3: Year over Year Change in Commercial Bank Interest Received and Paid, as a Share of Assets, and the Federal Funds Rates

 

Fig. 4: Year over Year Change in Commercial Bank Interest Received and Paid, as a Share of Assets

 

Both figures show that rising rates are associated with narrower commercial bank spreads — that is, less profitable loans, not more profitable. (Note the steeper slope of the red line than the blue one in Figure 3.) Again, this is not surprising — since banks borrow short and lend long, their average funding costs change more quickly than their average lending rates do. The most recent three tightening episodes were all associated with narrower spreads, not wider ones. Over 2004-2006, banks’ funding costs rose by 1.5 points while the average rate on their loans rose by only 1.3 points. In 1999-2000, funding costs rose by 0.55 points while loan rates rose by 0.45 points. And in 1994-1996, bank funding costs rose by 0.6 points while loan rates rose by 0.4 points. Conversely, during the period of falling rates in 2007-2008, bank funding costs fell by 1.7 points while average loan rates fell by only 1.4 points. Admittedly, these are all rather small changes — what is most striking about banking spreads is their stability.  But the important thing is that past tightening episodes have consistently reduced the lending profits of commercial banks. Not increased them.

Thinking about the political economy of support for higher rates, as Krugman is doing, is asking the right question. And the idea that the narrow interests of commercial banks could be important here, is reasonable on its face. But the idea that higher rates are associated with higher lending spreads, just doesn’t seem to be supported by the data. Unfortunately, I don’t have a simple alternative story. As the late Bob Fitch used to say, 90 percent of what happens in the world can be explained by vulgar Marxism. But banks’ support for hard money may fall in the other 10 percent.

 

 

UPDATE: For what it’s worth, here are the results of regressions of average interest received by commercial banks and of and their average funding costs, on the Federal Funds rate. Both interest flows are normalized by total assets.

Full Period (1955-2014) 1955-1984 1985-2014
Coefficient r2 Coefficient r2 Coefficient r2
Funding 0.51 0.77 0.56 0.85 0.61 0.92
(0.04) (0.04) (0.03)
Lending 0.54 0.69 0.61 0.85 0.67 0.89
(0.05) (0.05) (0.04)
Funding 0.30 0.67 0.22 0.60 0.42 0.86
(0.03) (0.03) (0.03)
Lending 0.30 0.67 0.25 0.63 0.39 0.79
(0.03) (0.04) (0.04)

Again, we don’t see any support for the hypothesis that spreads systematically rise with interest rates. Depending on the period and on whether you look at levels or changes, you can see a slightly stronger relationship of the Federal Funds rate with either bank lending rates of funding costs; but none of these differences would pass a standard significance test.

Two positive conclusions come out of this. First, all the coefficients are substantially, and significantly, below 1. In other words,  the policy rate is passed through far from completely to market rates, even in the interbank market, which should be most closely linked to it. Second, looking at the bottom half of the table, we see that changes in the policy rate have a stronger affect on both the funding and lending rates (at least over a horizon of a year) today than they did in the postwar decades. This is not surprising, given the facts that non-interest-bearing deposits provided most bnk funding in the earlier period, and that monetary policy then worked through more limits on the quantity of credit than interest rates per se. But it’s interesting to see it so clearly in the data.

 

UPDATE 2: Krugman seems to be doubling down on the bank spreads theory. I hope he looks a bit at the historical data before committing too hard to this story.

 

VERY LATE UPDATE: In the table above, the first set of rows is levels; the second is year-over-year changes.

 

[1] This measure is not quite the same as the spread — for that, we would want to divide bank interest costs by their liabilities, or their interest-bearing liabilities, rather than their assets. But this measure, rather than the spread in the strict sense, is what’s relevant for the question we’re interested in, the effect of rate changes on bank lending profits. Insofar as bank loans are funded with equity, lending will become more profitable as rates rise, even if the spread is unchanged. For this reason, I refer to banks average funding costs, rather than average borrowing costs.

Mixed Messages from The Fed and the Bond Markets

It’s conventional opinion that the Fed will begin to raise its policy rate by the end of 2015, and continue raising rates for the next couple years. In the FT, Larry Summers argues that this will be a mistake. And he observes that bond markets don’t seem to share the conventional wisdom: “Long term bond markets are telling us that real interest rates are expected to be close to zero in the industrialised world over the next decade.”

The Summers column inspired me to take a look at bond prices and flesh out this observation. It is straightforward to calculate how much the value of a bond change in response to a change in interest rates. So by looking at the current yields on bonds of different maturities, we can see what expectations of future rate changes are consistent with profit-maximizing behavior in bond markets. [1]

The following changes shows the yields of Treasury bonds of various maturities, and the capital loss for each bond from a one-point rise in yield over the next year. (All values are in percentage points.)

Maturity Yield as of July 2015 Value Change from 1-Point Rise
30 year 3.07 -17.1
20 year 2.77 -13.9
10 year 2.32 -8.4
5 year 1.63 -4.6
1 year 0.30 -0.0

So if the 30-year rate rises by one point over the next year, someone who just bought a 30-year bond will suffer a 17 percent capital loss.

It’s clear from these numbers that Summers is right. If, over the next couple of years, interest rates were to “normalize” to their mid-90s levels (about 3 points higher than today), long bonds would lose half their value. Obviously, no one would hold bonds at today’s yields if they thought there was an appreciable chance of that happening.

We can be more precise. For any pair of bonds, the ratio of the difference in yields to the difference in capital losses from a rate increase, is a measure of the probability assigned by market participants to that increase. For example, purchasing a 20-year bond rather than a 30-year bond means giving up 0.3 percentage points of yield over the next year, in return for losing only 14 percent rather than 17 percent if there’s a general 1-point increase in rates. Whether that looks like a good or bad tradeoff will depend on how you think rates are likely to change.

For any pair of bonds, we can calculate the change in interest rates (across the whole yield curve) that would keep the overall return just equal between them. Using the average yields for July, we get:

30-year vs 20-year: +0.094%

30-year vs. 10-year: +0.086%

30-year vs. 5-year: +0.115%

20-year vs. 10-year +0.082%

20-year vs. 5 year: + 0.082%

Treasury bonds seem to be priced consistent with an expected tenth of a percent or so increase in interest rates over the next year.

In other words: If you buy a 30 year bond rather than a 20-year one, or a 20-year rather than 10-year, you will get a higher interest rate. But if it turns out that market rates rise by about 0.1 percentage points (10 basis points) over the next year, the greater capital losses on longer bonds will just balance their higher yields. So if you believe that interest rates in general will be about 10 basis points higher a year from now than they are now, you should be just indifferent between purchasing Treasuries of different maturities. If you expect a larger increase in rates, long bonds will look overpriced and you’ll want to sell them; if you expect a smaller increase in rates than this, or a decrease, then long bonds will look cheap to you and you’ll want to buy them. [2]

A couple of things to take from this.

First, there is the familiar Keynesian point about the liquidity trap. When long rates are low, even a modest increase implies very large capital losses for holders of long bonds. Fear of these losses can set a floor on long rates well above prevailing short rates. This, and not the zero lower bound per se, is the “liquidity trap” described in The General Theory.

Second,  compare the implied forecast of a tenth of a point increase in rates implied by today’s bond prices, to the forecasts in the FOMC dot plot. The median member of the FOMC expects an increase of more than half a point this year, 2 points by the end of 2016, and 3 points by the end of 2017. So policymakers at the Fed are predicting a pace of rate increases more than ten times faster than what seems to be incorporated into bond prices.

FOMC dotplot

If the whole rate structure moves in line with the FOMC forecasts, the next few years will see the biggest losses in bond markets since the 1970s. Yet investors are still holding bonds at what are historically very low yields. Evidently either bond market participants do not believe that Fed will do what it says it will, or they don’t believe that changes in policy rate will have any noticeable effect on longer rates.

And note: The belief that long rates unlikely to change much, may itself prevent them from changing much. Remember, for a 30-year bond currently yielding 3 percent, a one point change in the prevailing interest rate leads to a 17 point capital loss (or gain, in the case of a fall in rates). So if you have even a moderately strong belief that 3 percent is the most likely or “normal” yield for this bond, you will sell or buy quickly when rates depart much from this. Which will prevent such departures from happening, and validate beliefs about the normal rate. So we shouldn’t necessarily expect to see the whole rate structure moving up and down together. Rather, long rates will stay near a conventional level (or at least above a conventional floor) regardless of what happens to short rates.

This suggests that we shouldn’t really be thinking about a uniform shift in the rate structure. (Though it’s still worth analyzing that case as a baseline.) Rather, an increase in rates, if it happens, will most likely be confined to the short end. The structure of bond yields seems to fit this prediction. As noted above, the yield curve at longer maturities implies an expected rate increase on the order of 10 basis points (a tenth of a percentage point), the 10-year vs 5 year, 10 year vs 1 year, and 5 year vs 1 year bonds imply epected increases of 18, 24 and 29 basis points respectively. This is still much less than dot plot, but it is consistent with idea that bond markets expect any rate increase to be limited to shorter maturities.

In short: Current prices of long bonds imply that market participants are confident that rates will not rise substantially over the next few years. Conventional wisdom, shared by policymakers at the Fed, says that they will. The Fed is looking at a two point increase over the next year and half, while bond rates imply that it will take twenty years. So either Fed won’t do what it says it will, or it won’t affect long rates, or bondholders will get a very unpleasant surprise. The only way everyone can be right is if trnasmission from policy rate to long rates is very slow — which would make the policy rate an unsuitable tool for countercyclical policy.

This last point is something that has always puzzled me about standard accounts of monetary policy. The central bank is supposed to be offsetting cyclical fluctuations by altering the terms of loan contracts whose maturities are much longer than typical business cycle frequencies. Corporate bonds average about 10 years, home mortgages, home mortgages of course close to 30. (And housing seems to be the sector most sensitive to policy changes.) So either policy depends on systematically misleading market participants, to convince them that cyclical rate changes are permanent; or else monetary policy must work in some completely different way than the familiar interest rate channel.

 

 

[1] In the real world things are more complicated, both because the structure of expectations is more complex than a scalar expected rate change over the next period, and because bonds are priced for their liquidity as well as for their return.

[2] I should insist in passing, for my brothers and sisters in heterodoxy, that this sort of analysis does not depend in any way on “consumers” or “households” optimizing anything, or on rational expectations. We are talking about real markets composed of profit-seeking investors, who certainly hold some expectations about the future even if they are mistaken.

Draghi Makes His Case

A few unorganized thoughts on yesterday’s press conference. Video is here. Transcript is … do they even publish transcripts of these things?

Draghi’s introductory remarks didn’t mention Greece but of course that’s what all the questions were about. The big question were about liquidity assistance (ELA) to Greek banks and under what conditions Greek debt would be included in quantitative easing, a big expansion of which was just announced.

There’s no way to hide the hypocrisy of the simultaneous expansion of QE and continued limits on ELA. You can say, the markets don’t want to hold this debt so we need to reduce our holdings too, to avoid excessive risk — then you are acting like a private bank. Or you can say, the markets don’t want to hold this debt so we need to increase our holdings, to keep its yield down — then you are acting like a central bank. But there’s no basis for applying one of these logics to Greece and the other to the rest of the euro area.

There was also no explanation for the decision to raise the ELA cap by 900 million. Draghi kept repeating the formula “solvent banks with adequate collateral” but obviously this implies a bank by bank assessment, not a hard cap for the country as a whole. Anyway, the logic of a lender of last resort is that, if you are going to support the banks, you need to be prepared to lend as much as it takes. A limited program only makes the problem worse, by encouraging depositors and other holders of short-term liabilities to get out before its exhausted. Paul de Grauwe has the right analysis here:

The correct announcement of the ECB should be that it will provide all the necessary liquidity to the Greek banks. Such an announcement will pacify depositors. Knowing that the banks have sufficient cash to pay them out they will stop running to the bank. Like the OMT, such an announcement will stop the banking crisis without the ECB actually having to provide much liquidity to the Greek banks.

These are first principles of how a central bank should deal with a banking crisis. I would be very surprised if the very intelligent men (and one woman) in Frankfurt did not know these first principles. This leads me to conclude that the ECB has other objectives than stabilizing the Greek banking system. These objectives are political. The ECB continues to put pressure on the Greek government to behave well. The price of this behavior by the ECB is paid by millions of Greeks.

Logically, ELA should either be ended or else provided on the a sufficient scale to restore confidence and end the run. Draghi suggested that there was something moderate and “proportional” about choosing a course in between, but this is incoherent. I was also very struck that he felt the need to reject the accusation that “there was bank run deliberately caused by the ECB,” which no one there had made. Remember that old line, attributed to Claud Cockburn: Never believe something until it’s been officially denied.

Another thing I found interesting was how much he treated the Bank of Greece as an independent actor, frequently referring to decisions “taken by the ECB and the Bank of Greece” and even trying to pass the buck to them on questions like whether the additional ELA was sufficient (“we have fully accommodated the Bank of Greece’s request”) and when the Greek banks would be able to reopen. Establishing that the national central banks have independent authority will be important if they become a terrain of struggle in future conflicts between popular governments and the euro authorities.

On the question of when the Greek banks would reopen, after deferring to the BoG, he then said that they hold all this government paper (which isn’t actually true — the ECB’s own numbers show that Greek banks have the lowest proportion of government loans on their books of any major euro-area country) and their solvency and the adequacy of their collateral therefore depend on what’s going on with the government. “The quality of the collateral depends on the quality of the discussions” with the creditors was one way he put it, a more or less explicit acknowledgement that this decision is being made on political criteria.

Someone asked him point-blank how the Greek banks could be ineligible for assistance when the ECB’s own analysis had concluded they were solvent; someone else asked why a hard cap was being announced when this was never done for individual banks, precisely because of concerns wit would intensify a panic. At this point (around 40:00 in the video) he changed tack again. Now he said that this was a special case because it wasn’t about conditions at individual banks but about a “systemic” problem of a whole banking system, so the old rules didn’t apply. Which of course made nonsense of the “solvency and adequate collateral” formula, without doing anything to justify the ECB’s actions.

On the question of whether or when Greek bonds would be included in QE, Draghi’s initial non-answer was “when they become eligible for monetary policy.” Pressed by the reporter (around 56:00), he turned to vice-president Constâncio, who explained that if a country’s bonds were rated below investment-grade, they could only be purchased by the ECB if (1) there was an IMF program in place and (2) the ECB’s Governing Council determines that there is “credible compliance” with the program. [1] Here again we see how monetary policy is used to advance a particular policy agenda, and more broadly, a nice illustration of how market and state power articulate. The supposed judgement of the markets is actually enforced by public agencies.

One of the few departures from Greece was when Draghi got going — I can’t remember in response to what — about the need for deeper “capital market integration.” Which seems nuts. Who, looking at the situation in Europe today, would say, You know what we really need? More uncontrolled international lending. It’s just like Dani Rodrik’s parable:

Imagine landing on a planet that runs on widgets. You are told that international trade in widgets is highly unpredictable and volatile on this planet, for reasons that are poorly understood. A small number of nations have access to imported widgets, while many others are completely shut out even when they impose no apparent obstacles to trade. With some regularity, those countries that have access to widgets get too much of a good thing, and their markets are flooded with imported widgets. This allows them to go on a widget binge, which makes everyone pretty happy for a while. However, such binges are often interrupted by a sudden cutoff in supply, unrelated to any change in circumstances. The turnaround causes the affected economies to experience painful economic adjustments. For reasons equally poorly understood, when one country is hit by a supply cutback in this fashion, many other countries experience similar shocks in quick succession. Some years thereafter, a widget boom starts anew.

Your hosts beg you for guidance: how should they deal with their widget problem? Ponder this question for a while and then ponder under what circumstances your central recommendation would be that all extant controls on international trade in widgets be eliminated.

 

[1] I’m not sure but I believe these standards were established by the ECB itself, and not by any of its governing legislation. So the answer is evasive in another way. In general, watching these things makes clear how helpful it is in resisting popular pressure to have multiple, shifting, overlapping authorities. Any decision can be presented as an objective constraint imposed from somewhere else.

 

UPDATE: Nathan Tankus has some very sharp observations on the press conference.

 

The Non-Accelerating What Now Rate of Inflation

The NAIRU is back. Here’s Justin Wolfers in the Times the other day:

My colleague Neil Irwin wrote about this slow wage growth as if it were bad news. I feel much more optimistic. … It is only when nominal wage growth exceeds the sum of inflation (about 2 percent) and productivity growth (about 1.5 percent) that the Fed needs to be concerned…

Read that last sentence again. What is it that would be accelerating here?

The change in the wage share is equal to the increase in average nominal wages, less inflation and the increase in labor productivity. This is just accounting. So Wolfer’s condition, that wage growth not exceed the sum of inflation and labor productivity growth is, precisely, the condition that the wage share not rise. If we take him literally — and I don’t see why we shouldn’t — then the Fed should be less concerned to raise rates when inflation is higher. Which makes no sense if the goal is to control inflation. But perfect sense if the real concern is to prevent a rise in the wage share.

Four Questions about Fiscal Policy

Earlier this fall, I spent a pleasant few days at the 12th Post Keynesian Conference in Kansas City, including a long chat over beers with Robert Skidelsky. In addition to presenting some of my current work, I took part in an interesting roundtable discussion of functional finance with Steve Fazzari, Peter Skott, Marc Lavoie and Mario Seccarechia. Here is an edited version of what I said.

* * *

We all agree that fiscal policy is effective. If output is too low, by whatever standard, higher public spending or lower taxes will cause it to rise. And we all agree that the current level of public debt has no implications for the feasibility or desirability of fiscal policy, at least in a country like the United States. In the wider world that might be a controversial statement but in this room it is not.

It’s not productive to repeat points on which we all agree. So instead, I want to pose four questions about functional finance on which there is not a consensus. These aren’t questions I necessarily have (or expect to hear) good answers to at the moment, but ones that I hope will be the focus of future work. First, the political economy question. Why does the idea of a government financial constraint have such a tenacious hold on both the policy conversation and the economics profession? What function, what interest, does this idea serve? Second, how confident are we about the level of aggregate expenditure that policy should target? Is there a well-defined level of potential output that corresponds to both full employment and price stability? Third, what is the problem that we imagine fiscal policy to be solving? Is it stabilizing of output in the face of “shocks” of some kind, or is it adjusting the long term trend? And what are the sources for the variation in private demand to which policy must respond? Finally, if functional finance means that fiscal policy replaces monetary policy as the main tool for managing aggregate expenditure, what role does that leave for the interest rate?

1. The political economy question.  We all agree that in a country like the modern United States (or the EU as a whole), public budgets are never constrained by the willingness of the private sector to hold the government’s liabilities. There are a number of routes, both logical and empirical, to reach this conclusion, which I won’t repeat here. And yet both policymakers and academic economists are, with few exceptions, committed to the idea that government does face a financial constraint. I don’t think it’s a sufficient explanation that people are just stupid. I was on an earlier panel with Randy Wray, where he quoted Paul Samuelson describing the idea of a government financial constraint as “religion” that has no rational basis but is nonetheless “scares people … into behaving the way that civilized life requires.” [1] Randy focused, understandably, on the first half of that quote, the acknowledgement that a balanced budget is desirable only on ritual or aesthetic criteria. But what about the second part? What is the civilized life that benefits from this taboo?

The political salience of the balanced-budegt myth has been particularly clear in the debt-ceiling fights of the past few years.  You read John Cassidy in New Yorker: “Every country needs to pay its creditors or face ruin.” [2] This is framed as a statement of fact, but it really describes a political project. Creditors need to threaten countries with ruin if they are going to be obeyed. The threat doesn’t have to be real, but it does have to be believed.

The most important political use of the government budget constraint today is undoubtedly in the Euro area, where it seems clear that a central part of the elite motivation for the single currency was precisely to reimpose financial constraints on national governments. This view of the euro project was forcefully expressed by Massimo Pivetti in a 2013 article in Contributions to Political Economy. As he puts it, the ultimate effect of European countries’ renunciation of monetary sovereignty has been the dismantling of the social democratic order.

What is being liquidated is but one of the most advanced experiences of civil coexistence the world has ever known—in fact, the greatest ever achievement of the bourgeois civilization. … 

Surrender of national sovereignty in the monetary and fiscal fields subscribed by European governments produced a situation of political ‘irresponsibility’, which greatly facilitated their declining commitment to high employment and the redistribution of income, as well as the priority given to reducing inflation, the gradual dismantling of the welfare state, and the privatization drive. …  [The euro] is an infernal machine: a machine born out of a deliberate continental project to undermine wage earners’ bargaining powers.

Wolfgang Streeck similarly argues that policies that result in rising debt are not the result of rising demands for redistribution and public services, but rather have been supported by the wealthy, precisely because “rising public debt can be utilized politically to argue for cutbacks in state spending and for privati­zation of public services.” You can find similar arguments by Perry Anderson (in The New Old World), Gindin and Panitch, and others. Financial constraint “disciplines” “irresponsible” policymakers — in other words, it makes them responsive to the interests of owners of financial assets. And I would stress the same fundamental point emphasized by Gindin and Panitch — the interest that counts here is not a direct pecuniary interest, defined within the economic system. It is the interest of wealthowners as a class in the perpetuation of a social order based on the accumulation of private wealth.

2. Next, I think we need to interrogate the notion of potential output more critically. The assumption of almost the entire functional finance literature — including my own work — is that there is a well-defined level of aggregate expenditure that policy should be targeting, which corresponds to full employment and full utilization of society’s resources. In the standard formula, once we see rising inflation, we know that this target has been reached and there should be no further expansionary policy. In this respect, there is no difference between functional finance and mainstream policy thought. The difference is about the tools used, not about the goal. Most importantly, both policy orthodoxy and functional finance assume that neither inflation nor employment is affected directly by macroeconomic policy, but only via the level of output. So output, inflation and employment can be treated as three indicators for a single target. [3]

It is not obvious, though, why the goals of full employment, price stability and steady output growth should always coincide. Now, in practice it may be that they generally do, or at least are close enough that this is not a big problem. One thing Arjun and I do in our paper is examine this question directly. We compute a number of different measures of the output gap from 1953 to the present. We compare output gaps based on the deviation of current output from trend, the level of unemployment, the level of inflation, and the change in inflation, as well as a measure combining unemployment and the change in inflation that corresponds to the Taylor rule. The interesting thing is that these different measures perform very similarly. The output and unemployment measures fit especially closely, with a simple correlation coefficient of 0.94.  In other words, the Okun relationship between output and unemployment is very stable, and the Phillips curve relationship between output or employment and inflation is also fairly stable. So the statement “When output is above trend, you will see rising inflation; when output is below trend, you will see high unemployment” does in fact seem to be a reliable generalization. (See figure below.)

The figure shows measures of the difference between current output and potential based on (1) trend GDP, as computed by the BEA; (2) the deviation of unemployment from its long-term average; (3) the average of the deviations of unemployment and inflation from their long-term averages; (4) the average of the deviation of unemployment from average and the year-over-year change in inflation; and (5) the year-over-year change in inflation. 

But even if these measures agree with each other for the US over the past 60 years, that doesn’t mean they will agree in other times and places. And in fact, we see that the inflation-change measure does not agree with the others for the post-2007 period, suggesting a much smaller negative output gap. (This is because inflation has stabilized at a low level, rather than continuing to fall.) And even if these measures do generally agree with each other, that doesn’t mean they are right, or that interpreting them is straightforward. In particular, we should ask if hysteresis might not be a more general phenomenon, and that the inflation that comes with output above potential isn’t better thought of as an adjustment cost. This brings me to the next question.

3. Is aggregate demand only an issue in the short run, or does it matter in the long run as well? In other words, is the problem to be solved by policy deviations of output around a trend that is determined on the supply side, or is the trend itself the object of policy?

If the former, shouldn’t we have a more positive theory about what these “shocks” are that policy is responding to. This has always struck me as one of the weirdest lacunae in mainstream macro. The entire problem of policy in this framework is responding to these shocks, so you would think that a central question would be where they come from, how large they are, whether there are identifiable factors that affect their distribution. But instead the existence of these vaguely defined “shocks” is just the unquestioned starting point of analysis. Now obviously there are reasons for this. Shocks, by definition, are changes in the state of the world that are not due to rational optimization, so if that’s your methodology, then “shocks” just means “things I have nothing to say about.” (And I have a sneaking suspicion that there is a logical inconsistency between the existence of unanticipated shocks and the idea of intertemporal equilibrium. But maybe not.) But on our side we don’t have that excuse. We shouldn’t limit ourselves to showing that changes in the government budget position can offset changes in desired private spending. We should try to explain why desired private spending varies so dramatically.

And what if demand matters in the long run, thanks to hysteresis (and what I call anti-hysteresis) in the laborforce, and Verdoorn-Kaldor changes in productivity growth? [4] In that case these questions are even more urgent. And we also have to face the political question that was banished from respectable macro in the 1980s: What is the desirable tradeoff between output and inflation? More broadly, if we can’t take a given path of potential output as given, how do we define the goals of macro policy?

4. What is the role of interest rate policy in a functional finance framework, given that it is no longer the primary tool for adjusting aggregate expenditure? On Thursday’s panel, we had three different answers to this question. Arjun and I say that if for whatever reason the public debt to GDP ratio is a concern for policymakers, adjusting the policy interest rate is in general sufficient to stabilize that ratio at some desired level. Peter Skott says that if we have some idea of the optimal long-run capital-output ratio (or perhaps more precisely, the optimal choice of technique), the interest rate can be set to achieve that. And Randy says that we shouldn’t worry about the debt-GDP ratio and that business investment decisions are not very responsive to the interest rate, so its main consequences are distributional. Since there is no social interest in providing a passive, risk-free income to rentiers, the nominal interest rate should be set to zero permanently.

[1] The quote is from an interview with Mark Blaug:  “I think there is an element of truth in the view that the superstition that the budget must be balanced at all times [is necessary]. Once it is debunked [that] takes away one of the bulwarks that every society must have against expenditure out of control. There must be discipline in the allocation of resources or you will have anarchistic chaos and inefficiency. And one of the functions of old fashioned religion was to scare people by sometimes what might be regarded as myths into behaving in a way that the long-run civilized life requires.”

[2] The title of the piece is “Why America Needs a Stock Market Crash.”

[3] This isn’t strictly correct, since an important component of functional finance in its modern UMKC form is a job guarantee or employer of last resort (ELR) policy. But given the stability of the Okun relationship, employment and output can safely be treated as a single target in practice. The problem is the relationship of employment and output, on the one hand, with inflation, on the other.

[4] As late as the 1980s, people like Tobin took it for granted that the reason that inflationary or deflationary gaps would not continue indefinitely, was that aggregate supply would adjust.

Five Thoughts on Monetary Policy

1. Monetary policy may operate on (a) the quantity of bank liabilities (money); (b) the quantity of bank assets (credit); (c) the price of one or more assets relative to money (an interest rate);  and/or (d) the price of money, normally relative to some other money (an exchange rate). Which of these should be considered the most immediate target of central bank policy, both practically and conceptually, has been debated for over 200 years. All four positions are well-represented in both academic literature and central bank policymaking. For the US over the past 50 years, you could say that the center of gravity — both in policy and in the economics profession — has shifted from the quantity of credit to the quantity of money, and then from the quantity of money to the price of credit. [*] I don’t know of any good historical account of these recent shifts, but they come through dramatically if you compare contemporary articles on monetary policy, ones from 20 years ago, and ones from 50 years ago.

Lance Taylor has a good discussion of the parallel debates in the 19th century on pages 68-84 of Maynard’s Revenge, and a somewhat more technical version in chapter 3 of Reconstructing Macroeconomics. Below, I reproduce his table classifying various early monetary theorists in the four categories above, and on the orthogonal dimension of whether the money/credit system is supposed to be active or passive with respect to the economy. Obviously, confidence about the usefulness of monetary policy implies a position on the lower half of the table.

From Lance Taylor, Reconstructing Macroeconomics

It would be foolish to debate which of these positions is the correct one — though the monetarist view that the quantity of money plays an important causal role is clearly inapplicable to modern economies. It also seems possible that we may be seeing a shift away from the focus on the price of credit, and specifically the single policy interest rate — a position that is presented in many recent textbooks as the only possible one, even though it has been dominant only since the 1990s. In general what we should be doing is recognizing the diversity of positions and exploring the historical contexts in which one or another comes to dominate.

2. Regardless of which margin it operates on, monetary policy in its modern sense typically targets a level of aggregate output. This means changing how tightly liquidity constraints bind current expenditure. In other words, how easy is it for a unit that wants to increase its spending to acquire money, either by selling additional current output, selling an asset, or issuing a new liability? So regardless of the immediate target of monetary policy, the intermediate target is liquidity. (So what’s the point? The point is liquidity. The point is liquidity. The point is liquidity.) This may seem obvious, but keeping this idea in mind helps, I think, to cut through a lot of confusion. Expansionary policy makes it easier for someone to finance increased spending relative to income. Contractionary policy makes it harder.

3. Orthodox macroeconomics confuses the issue by assuming a world of infinite liquidity, where anyone can spend as much they like in any given period, subject to an intertemporal budget constraint that their spending over the infinite future must equal their income over that same infinite future. This condition — or equivalently the transversality or no-Ponzi condition — is coherent as a property of mathematical model. But  it is meaningless as applied to observable economic behavior. The only way my spending over my whole lifetime can be limited, is if my spending in some particular period is limited. Conversely, if I can spend as much as I want over any finite horizon, then logically I can spend as much as I want over an infinite horizon too. The orthodox solution is literally to just add an assumption saying “No you can’t,” without any explanation for where this limitation comes from. In reality, any financial constraint that rules out any trajectory of lifetime spending in excess of lifetime income will rule out some trajectories in which lifetime spending is less than lifetime income as well.

More concretely, orthodox theory approaches monetary policy through the lens of a consumption loan, in which the interest rate represents not the terms on which increased expenditure today can be financed, but the terms on which expenditure today trades off against expenditure in the future. In reality, consumption loans — while they do exist — are a very small fraction of total debt. The vast majority of private loans are taken to finance assets, which are expected to be income-positive. The models you find in graduate textbooks, in which the interest rate reflects a choice between consumption now and consumption later, have zero connection with real-world interest rates. The vast majority of loans are incurred to acquire an asset whose return will exceed the cost of the loan. So the expectation is that spending in the future will be higher, not lower, as a result of borrowing today. And of course nobody in the policy world believes in consumption loans or the interest rate as an intertemporal price or the intertemporal budget constraint or any of that. (Just compare Bernanke’s article on “The Credit Channel of Monetary Policy Transmission” with Woodford’s Interest and Prices, the most widely used New Keynesian graduate textbook. These are both “mainstream” economists, but there is zero conceptual overlap.) If you are not already stuck in the flybottle of academic economics there is no reason to worry about this stuff. Interest is not the price of consumption today vs. consumption tomorrow, it’s the price of money or of liquidity.

4. The fundamental tradeoff in the financial system is between flexibility and stability. The capacity of the financial system to delink expenditure from income is the whole point of it but also why it contributes to instability. Think of it this way: The same flexibility that allows an entrepreneur to ignore market signals to introduce a new product or process, allow someone to borrow money for a project that will never pay off. In general, it’s not clear until after the fact which is which. Monetary reforms respond to this tension by simultaneously aiming at making the system more rigid and at making it more flexible. This fundamental conflict is often obscured by the focus on specific mechanisms and by fact that same person often wants both. Go back to Hume, who opposed the use of bank-credit for payments and thought a perfect circulation was one in which the quantity of money was just equal to the amount of gold. But who also praised early banks for allowing merchants to “coin their whole wealth.”

You could also think of liquidity as providing a bridge for expenditure over dips in income. This is helpful when the fall is short-term — the existence of liquidity avoids unnecessary fluctuations in spending (and in aggregate income). But it is a problem when the fall is lasting — eventually, expenditure will have to confirm, and putting the adjustment off makes it larger and more disruptive when it comes. This logic is familiar in the business press, applied in particular, in a moralizing way, to public debt. But the problem is more general and doesn’t admit of a general solution. A more flexible credit system smooths over short-term fluctuations but allows more dangerous long-term imbalances to develop. A more rigid system prevents the development of any large imbalances but means you feel every little bump right up your spine.


(EDIT: On Twitter, Steve Randy Waldman points out that the above paragraph sits uncomfortably with my rejection of the idea of consumption loans. I should probably rewrite it.)
5. Politically, the fundamental fact about monetary policy is that it is central planning that cannot speak its name. The term “natural interest rate” was introduced by Wicksell, introduced to the English-speaking world by Hayek, and reintroduced by Friedman to refer specifically to the interest rate set by the central bank. It becomes necessary to assert that the interest rate is natural only once it is visibly a political question. And this isn’t only about the rhetoric of economics: Practical monetary policy continues to be constrained by the need for the outcome of policy choices to be disguised in this way.

Mike Konczal has a good discussion of how this need to maintain the appearance of “natural”market outcomes has hamstringed policy since 2008.

Starting in December 2012, the Federal Reserve started buying $45 billion a month of long-term Treasuries. Part of the reason was to push down the interest rates on those Treasuries and boost the economy. But what if the Fed … had picked a price for long-term securities, and then figured out how much it would have to buy to get there? Then it would have said, “we aim to set the 10-year Treasury rate at 1.5 percent for the rest of the year” instead of “we will buy $45 billion a month of long-term Treasuries.” This is what the Fed does with short-term interest rates… 

What difference would this have made? The first is that it would be far easier to understand what the Federal Reserve was trying to do over time. … The second is that it might have been easier. … the markets are unlikely to go against the Fed … the third is that if low interest rates are the new normal, through secular stagnation or otherwise, these tools will need to be formalized. … 

The normal economic argument against this is that all the action can be done with the short-rate. … the real argument is political. … the Federal Reserve would be accused of planning the economy by setting long-term interest rates. So it essentially has to sneak around this argument by adjusting quantities. … As Greta R. Krippner notes in her excellent Capitalizing on Crisis, in 1982 Frank Morris of the Boston Fed argued against ending their disaster tour with monetarism by saying, “I think it would be a big mistake to acknowledge that we were willing to peg interest rates again. The presence of an [M1] target has sheltered the central bank from a direct sense of responsibility for interest rates.” 

I agree with Mike: The failure of the Fed to announce a price target for long bonds is a clear sign of the political limits to monetary policy. (Keynes, incidentally, came to support fiscal policy only after observing the same constraints on the Bank of England in the 1920s.) There is a profound ideological resistance to acknowledging that monetary policy is a form of planning. For a vivid example of this ideology in the wild, just go to the FRED website and look up the Federal Funds rate. Deciding on the level of the Fed Funds rate is the primary responsibility of the Federal Reserve, it’s the job of Janet Yellen and the rest of the FOMC. But according to the official documentation, this rate is “essentially determined by the market” and merely “influenced by the Federal Reserve.” There is a profound resistance, inscribed right in the data, to the idea that interest rates are consciously chosen consciously rather than somehow determined naturally in the market.

[*] This is a better description of the evolution of monetary theory than the evolution of monetary policy. It might be more accurate to say that policy went directly from targeting the quantity of credit to the price of credit, with the transitional period of attention to monetary aggregates just window dressing.

Alvin Hansen on Monetary Policy

The more you read in the history of macroeconomics and monetary theory, the more you find that current debates are reprises of arguments from 50, 100 or 200 years ago.

I’ve just been reading Perry Mehrling’s The Money Interest and the Public Interest, which  is one of the two best books I know of on this subject. (The other is Arie Arnon’s Monetary Theory and Policy Since David Hume and Adam Smith.) About a third of the book is devoted to Alvin Hansen, and it inspired me to look up some of Hansen’s writings from the 1940s and 50s. I was especially struck by this 1955 article on monetary policy. It not only anticipates much of current discussions of monetary policy — quantitative easing, the maturity structure of public debt, the need for coordination between the fiscal and monetary policy, and more broadly, the limits of a single interest rate instrument as a tool of macroeconomic management — but mostly takes them for granted as starting points for its analysis. It’s hard not to feel that macro policy debates have regressed over the past 60 years.

The context of the argument is the Treasury-Federal Reserve Accord of 1951, following which the Fed was no longer committed to maintaining fixed rates on treasury bonds of various maturities. [1] The freeing of the Fed from the overriding responsibility of stabilizing the market for government debt, led to scholarly and political debates about the new role for monetary policy. In this article, Hansen is responding to several years of legislative debate on this question, most recently the 1954 Senate hearings which included testimony from the Treasury department, the Fed Board’s Open Market Committee, and the New York Fed.

Hansen begins by expressing relief that none of the testimony raised

the phony question whether or not the government securities market is “free.” A central bank cannot perform its functions without powerfully affecting the prices of government securities.

He then expresses what he sees as the consensus view that it is the quantity of credit that is the main object of monetary policy, as opposed to either the quantity of money (a non-issue) or the price of credit (a real but secondary issue), that is, the interest rate.

Perhaps we could all agree that (however important other issues may be) control of the credit base is the gist of monetary management. Wise management, as I see it, should ensure adequate liquidity in the usual case, and moderate monetary restraint (employed in conjunction with other more powerful measures) when needed to check inflation. No doubt others, who see no danger in rather violent fluctuations in interest rates (entailing also violent fluctuations in capital values), would put it differently. But at any rate there is agreement, I take it, that the central bank should create a generous dose of liquidity when resources are not fully employed. From this standpoint the volume of reserves is of primary importance.

Given that the interest rate is alsoan object of policy, the question becomes, which interest rate?

The question has to be raised: where should the central bank enter the market -short-term only, or all along the gamut of maturities?

I don’t believe this is a question that economists asked much in the decades before the Great Recession. In most macro models I’m familiar with, there is simply “the interest rate,” with the implicit assumption that the whole rate structure moves together so it doesn’t matter which specific rate the monetary authority targets. For Hansen, by contrast, the structure of interest rates — the term and “risk” premiums — is just as natural an object for policy as the overall level of rates. And since there is no assumption that the whole structure moves together, it makes a difference which particular rate(s) the central bank targets. What’s even more striking is that Hansen not only believes that it matters which rate the central bank targets, he is taking part in a conversation where this belief is shared on all sides.

Obviously it would make little difference what maturities were purchased or sold if any change in the volume of reserve money influenced merely the level of interest rates, leaving the internal structure of rates unaffected. … In the controversy here under discussion, the Board leans toward the view that … new impulses in the short market transmit themselves rapidly to the longer maturities. The New York Reserve Bank officials, on the contrary, lean toward the view that the lags are important. If there were no lags whatever, it would make no difference what maturities were dealt in. But of course the Board does not hold that there are no lags.

Not even the most conservative pole of the 1950s debate goes as far as today’s New Keynesian orthodoxy that monetary policy can be safely reduced to the setting of a single overnight interest rate.

The direct targeting of long rates is the essential innovation of so-called quantitative easing. [2] But to Hansen, the idea that interest rate policy should directly target long as well as short rates was obvious. More than that: As Hansen points out, the same point was made by Keynes 20 years earlier.

If the central bank limits itself to the short market, and if the lags are serious, the mere creation of large reserves may not lower the long-term rate. Keynes had this in mind when he wrote: “Perhaps a complex offer by the central bank to buy and sell at stated prices gilt-edged bonds of all maturities, in place of the single bank rate for short-term bills, is the most important practical improvement that can be made in the technique of monetary management. . . . The monetary authority often tends in practice to concentrate upon short-term debts and to leave the price of long-term debts to be influenced by belated and imperfect re- actions from the price of short-term debts.” ‘ Keynes, it should be added, wanted the central bank to deal not only in debts of all maturities, but also “to deal in debts of varying degrees of risk,” i.e., high grade private securities and perhaps state and local issues.

That’s a quote from The General Theory, with Hansen’s gloss.

Fast-forward to 2014. Today we find Benjamin Friedman — one of the smartest and most interesting orthodox economists on these issues — arguing that the one great change in central bank practices in the wake of the Great Recession is intervention in a range of securities beyond the shortest-term government debt. As far as I can tell, he has no idea that this “profound” innovation in the practice of monetary policy was already proposed by Keynes in 1936. But then, as Friedman rightly notes, “Macroeconomics is a field in which theory lags behind experience and practice, not the other way around.”

Even more interesting, the importance of the rate structure as a tool of macroeconomic policy was recognized not only by the Federal Reserve, but by the Treasury in its management of debt issues. Hansen continues:

Monetary policy can operate on two planes: (1) controlling the credit base – the volume of reserve balances- and (2) changing the interest rate structure. The Federal Reserve has now backed away from the second. The Treasury emphasized in these hearings that this is its special bailiwick. It supports, so it asserts, the System’s lead, by issuing short- terms or long-terms, as the case may be, according to whether the Federal Reserve is trying to expand or contract credit … it appears that we now have (whether by accident or design) a division of monetary management between the two agencies- a sort of informal cartel arrangement. The Federal Reserve limits itself to control of the volume of credit by operating exclusively in the short end of the market. The Treasury shifts from short-term to long-term issues when monetary restraint is called for, and back to short-term issues when expansion is desired.

This is amazing. It’s not that Keynesians like Hansen  propose that Treasury should issue longer or shorter debt based on macroeconomic conditions. Rather, it is taken for granted that it does choose maturities this way. And this is the conservative side in the debate, opposed to the side that says the central bank should manage the term structure directly.

Many Slackwire readers will have recently encountered the idea that the maturities of new debt should be evaluated as a kind of monetary policy. It’s on offer as the latest evidence for the genius of Larry Summers. Proposing that Treasury should issue short or long term debt based on goals for the overall term structure of interest rates, and not just on minimizing federal borrowing costs, is the main point of Summers’ new Brookings paper, which has attracted its fair share of attention in the business press. No reader of that paper would guess that its big new idea was a commonplace of policy debates in the 1950s. [3]

Hansen goes on to raise some highly prescient concerns about the exaggerated claims being made for narrow monetary policy.

The Reserve authorities are far too eager to claim undue credit for the stability of prices which we have enjoyed since 1951. The position taken by the Board is not without danger, since Congress might well draw the conclusion that if monetary policy is indeed as powerful as indicated, nonmonetary measures [i.e. fiscal policy and price controls] are either unnecessary or may be drawn upon lightly.

This is indeed the conclusion that was drawn, more comprehensively than Hansen feared. The idea that setting an overnight interest rate is always sufficient to hold demand at the desired level has conquered the economics profession “as completely as the Holy Inquisition conquered Spain,” to coin a phrase. If you talk to a smart young macroeconomist today, you’ll find that the terms “aggregate demand was too low” and “the central bank set the interest rate too high” are used interchangeably. And if you ask, which interest rate?, they react the way a physicist might if you asked, the mass of which electron?

Faced with the argument that the inflation of the late 1940s, and price stability of the early 1950s, was due to bad and good interest rate policy respectively, Hansen offers an alternative view:

I am especially unhappy about the impli- cation that the price stability which we have enjoyed since February-March 1951 (and which everyone is justifiably happy about) could quite easily have been purchased for the entire postwar period (1945 to the present) had we only adopted the famous accord earlier …  The postwar cut in individual taxes and the removal of price, wage, and other controls in 1946 … did away once and for all with any really effective restraint on consumers. Under these circumstances the prevention of price inflation … [meant] restraint on investment. … Is it really credible that a drastic curtailment of investment would have been tolerated any more than the continuation of wartime taxation and controls? … In the final analysis, of course,  the then prevailing excess of demand was confronted with a limited supply of productive resources.

Inflation always comes down to this mismatch between “demand,” i.e. desired expenditure, and productive capacity.

Now we might say in response to such mismatches: Well, attempts to purchase more than we can produce will encourage increased capacity, and inflation is just a temporary transitional cost. Alternatively, we might seek to limit spending in various ways. In this second case, there is no difference of principle between an engineered rise in the interest rate, and direct controls on prices or spending. It is just a question of which particular categories of spending you want to hold down.

The point: Eighty years ago, Keynes suggested that what today is called quantitative easing should be a routine tool of monetary policy. Sixty years ago, Alvin Hansen believed that this insight had been accepted by all sides in macroeconomic debates, and that the importance of the term structure for macroeconomic activity guided the debt-issuance policies of Treasury as well as the market interventions of the Federal Reserve. Today, these seem like new discoveries. As the man says, the history of macroeconomics is mostly a great forgetting.

[1] I was surprised by how minimal the Wikipedia entry is. One of these days, I am going to start having students improve economics Wikipedia pages as a class assignment.

[2] What is “quantitative about this policy is that the Fed buys a a quantity of bonds, evidently in the hopes of forcing their price up, but does not announce an explicit target for the price. On the face of it, this is a strangely inefficient way to go about things. If the Fed announced a target for, say, 10-year Treasury bonds, it would have to buy far fewer of them — maybe none — since market expectations would do more of the work of moving the price. Why the Fed has hobbled itself in this way is a topic for another post.

[3] I am not the world’s biggest Larry Summers fan, to say the least. But I worry I’m giving him too hard a time in this case. Even if the argument of the paper is less original than its made out to be, it’s still correct, it’s still important, and it’s still missing from today’s policy debates. He and his coauthors have made a real contribution here. I also appreciate the Hansenian spirit in which Summers derides his opponents as “central bank independence freaks.”

The Call Is Coming from Inside the House

Paul Krugman wonders why no one listens to academic economists. Almost all the economists in the IGM Survey agree that the 2009 stimulus bill successfully reduced unemployment and that its benefits outweighed its costs. So why are these questions still controversial?

One answer is that economists don’t listen to themselves. More precisely, liberal economists like Krugman who want the state to take a more active role in managing the economy, continue to teach  an economic theory that has no place for activist policy.

Let me give a concrete example.

One of Krugman’s bugaboos is the persistence of claims that expansionary monetary policy must lead to higher inflation. Even after 5-plus years of ultra-loose policy with no rising inflation in sight, we keep hearing that since so “much money has been created…, there should already be considerable inflation.” (That’s from exhibit A in DeLong’s roundup of inflationphobia.) As an empirical matter, of course, Krugman is right. But where could someone have gotten this idea that an increase in the money supply must always lead to higher inflation? Perhaps from an undergraduate economics class? Very possibly — if that class used Krugman’s textbook.

Here’s what Krugman’s International Economics says about money and inflation:

A permanent increase in the money supply causes a proportional increase in the price level’s long-run value. … we should expect the data to show a clear-cut positive association between money supplies and price levels. If real-world data did not provide strong evidence that money supplies and price levels move together in the long run, the usefulness of the theory of money demand we have developed would be in severe doubt. 

… 

Sharp swings in inflation rates [are] accompanied by swings in growth rates of money supplies… On average, years with higher money growth also tend to be years with higher inflation. In addition, the data points cluster around the 45-degree line, along which money supplies and price levels increase in proportion. … the data confirm the strong long-run link between national money supplies and national price levels predicted by economic theory. 

… 

Although the price levels appear to display short-run stickiness in many countries, a change in the money supply creates immediate demand and cost pressures that eventually lead to future increases in the price level. 

… 

A permanent increase in the level of a country’s money supply ultimately results in a proportional rise in its price level but has no effect on the long-run values of the interest rate or real output. 

This last sentence is simply the claim that money is neutral in the long run, which Krugman continues to affirm on his blog. [1] The “long run” is not precisely defined here, but it is clearly not very long, since we are told that “Even year by year, there is a strong positive relation between average Latin American money supply growth and inflation.”

From the neutrality of money, a natural inference about policy is drawn:

Suppose the Fed wishes to stimulate the economy and therefore carries out an increase in the level of the U.S. money supply. … the U.S. price level is the sole variable changing in the long run along with the nominal exchange rate E$/€. … The only long-run effect of the U.S. money supply increase is to raise all dollar prices.

What is “the money supply”? In the US context, Krugman explicitly identifies it as M1, currency and checkable deposits, which (he says) is determined by the central bank. Since 2008, M1 has more than doubled in the US — an annual rate of increase of 11 percent, compared with an average of 2.5 percent over the preceding decade. Krugman’s textbook states, in  unambiguous terms, that such an acceleration of money growth will lead to a proportionate acceleration of inflation. He can hardly blame the inflation hawks for believing what he himself has taught a generation of economics students.

You might think these claims about money and inflation are unfortunate oversights, or asides from the main argument. They are not. The assumption that prices must eventually change in proportion to the central bank-determined money supply is central to the book’s four chapters on macroeconomic policy in an open economy. The entire discussion in these chapters is in terms of a version of the Dornbusch “overshooting” model. In this model, we assume that

1. Real exchange rates are fixed in the long run by purchasing power parity (PPP).
2. Interest rate differentials between countries are possible only if they are offset by expected changes in the nominal exchange rate.

Expansionary monetary policy means reducing interest rates here relative to the rest of the world. In a world of freely mobile capital, investors will hold our lower-return bonds only if they expect our nominal exchange rate to appreciate in the future. With the long-run real exchange rate pinned down by PPP, the expected future nominal exchange rate depends on expected inflation. So to determine what exchange rate today will make investors willing to holder our lower-interest bonds, we have to know how policy has changed their expectations of the future price level. Unless investors believe that changes in the money supply will translate reliably into changes in the price level, there is no way for monetary policy to operate in this model.

So  these are not throwaway lines. The more thoroughly a student understands the discussion in Krugman’s textbook, the stronger should be their belief that sustained expansionary monetary policy must be inflationary. Because if it is not, Krugman gives you no tools whatsoever to think about policy.

Let me anticipate a couple of objections:

Undergraduate textbooks don’t reflect the current state of economic theory. Sure, this is often true, for better or worse. (IS-LM has existed for decades only in the Hades of undergraduate instruction.) But it’s not much of a defense, is it? If Paul Krugman has been teaching his undergraduates economic theory that produces disastrous results when used as a guide for policy, you would think that would provoke some soul-searching on his part. But as far as I can tell, it hasn’t. But in this case I think the textbook does a good job summarizing the relevant scholarship. The textbook closely follows the model in Dornbusch’s Expectations and Exchange Rate Dynamics, which similarly depends on the assumption that the price level changes proportionately with the money supply. The Dornbusch article is among the most cited in open-economy macroeconomics and international finance, and continues to appear on international finance syllabuses in most top PhD programs.

Everything changes at the zero lower bound. Defending the textbook on the ground that it’s pre-ZLB effectively concedes that what economists were teaching before 2008 has become useless since then. (No wonder people don’t listen.) If orthodox theory as of 2007 has proved to be all wrong in the post-Lehmann world, shouldn’t that at least raise some doubts about whether it was all right pre-Lehmann? But again, that’s irrelevant here, since I am looking at the 9th Edition, published in 2011. And it does talk about the liquidity trap — not, to be sure, in the main chapters on macroeconomic policy, but in a two-page section at the end. The conclusion of that section is that while temporary increases in the money supply will be ineffective at the zero lower bond, a permanent increase will have the same effects as always: “Suppose the central bank can credibly promise to raise the money supply permanently … output will therefore expand, and the currency will depreciate.” (The accompanying diagram shows how the economy returns to full employment.) The only way such a policy might fail is if there is reason to believe that the increase in the money supply will subsequently be reversed. Just to underline the point, the further reading suggested on policy at the zero lower bound is an article by Lars Svennson that calls a permanent expansion in the money supply “the foolproof way” to escape a liquidity trap. There’s no suggestion here that the relationship between monetary policy and inflation is any less reliable at the ZLB; the only difference is that the higher inflation that must inevitably result from monetary expansion is now desirable rather than costly. This might help if Krugman were a market monetarist, and wanted to blame the whole Great Recession and slow recovery on bad policy by the Fed; but (to his credit) he isn’t and doesn’t.

Liberal Keynesian economists made a deal with the devil decades ago, when they conceded the theoretical high ground. Paul Krugman the textbook author says authoritatively that money is neutral in the long run and that a permanent increase in the money supply can only lead to inflation. Why shouldn’t people listen to him, and ignore Paul Krugman the blogger?

[1] That Krugman post also contains the following rather revealing explanation of his approach to textbook writing:

Why do AS-AD? First, you do want a quick introduction to the notion that supply shocks and demand shocks are different … and AS-AD gets you to that notion in a quick and dirty, back of the envelope way. 

Second — and this plays a surprisingly big role in my own pedagogical thinking — we do want, somewhere along the way, to get across the notion of the self-correcting economy, the notion that in the long run, we may all be dead, but that we also have a tendency to return to full employment via price flexibility. Or to put it differently, you do want somehow to make clear the notion (which even fairly Keynesian guys like me share) that money is neutral in the long run. That’s a relatively easy case to make in AS-AD; it raises all kinds of expositional problems if you replace the AD curve with a Taylor rule, which is, as I said, essentially a model of Bernanke’s mind.

This is striking for several reasons. First, Krugman wants students to believe in the “self-correcting economy,” even if this requires teaching them models that do not reflect the way professional economists think. Second, they should think that this self-correction happens through “price flexibility.” In other words, what he wants his students to look at, say, falling wages in Greece, and think that the problem must be that they have not fallen enough. That’s what “a return to full employment via price flexibility” means. Third, and most relevant for this post, this vision of self-correction-by-prices is directly linked to the idea that money is neutral in the long run — in other words, that a sustained increase in the money supply must eventually result in a proportionate increase in prices. What Krugman is saying here, in other words, is that a “surprising big” part of his thinking on pedagogy is how to inculcate the exact errors that drive him crazy in policy settings. But that’s what happens once you accept that your job as an educator is to produce ideological fables.

Where Do Interest Rates Come From?

What determines the level of interest rates? It seems like a simple question, but I don’t think economics — orthodox or heterodox — has an adequate answer.

One problem is that there are many different interest rates. So we have two questions: What determines the overall level of interest rates, and what determines the spreads between different interest rates? The latter in turn we can divide into the question of differences in rates between otherwise similar loans of different lengths (term spreads), differences in rates between otherwise similar loans denominated in different currencies, and all the remaining differences, grouped together under the possibly misleading name risk spreads.

In any case, economic theory offers various answers:

1. The orthodox answer, going back to the 18th century, is that the interest rate is a price that equates the desire to save with the desire to borrow. As reformulated in the later 19th century by Bohm-Bawerk, Cassel, etc., that means: The interest rate is the price of goods today relative to goods tomorrow. The interest rate is the price that balances the gains from deferring consumption with our willingness to do so. People generally prefer consumption today to consumption in the future, and because it will be possible to produce more in the future than today, so the interest rate is (normally) positive. This is a theory of all transactions that exchange spending in one period for spending (or income) in another, not specifically a theory of the interest rate on loans.

The Wicksell variant of this, which is today’s central-bank orthodoxy, is that there is a well-defined natural interest rate in this sense but that for some reason markets get this one price wrong.

2. An equally old idea is that the interest rate is the price of money. In Hume’s writings on money and interest, for instance, he vacillates between this and the previous story. It’s not a popular view in the economics profession but it’s well-represented in the business world and among populists and monetary reformers,. In this view, money is just another input to the production process, and the interest rate is its price. A creditor, in this view, isn’t someone deferring consumption to the future, but someone who — like a landlord — receives an income thanks to control of a necessary component of the production process. A business, let’s say, that needs to maintain a certain amount of working capital in the form of money or similarly liquid assets, may need to finance it with a loan on which it pays interest. Interest payments are in effect the rental price of money, set by supply and demand like anything else. As I say, this has never been a respectable view in economic theory, but you can find it in more empirical work, like this paper by Gabriel Chodorow-Reich, where credit is described in exactly these terms as an input to current production.

3. Keynes’ liquidity-preference story in The General Theory. Here again the interest rate is the price of money. But now instead of asking how much the marginal business borrower will pay for the use of money, we ask how much the marginal wealth owner needs to be compensated to give up the liquidity of money for a less-liquid bond. The other side of the market is given by a fixed stock of bonds; evidently we are dealing with a short enough period that the flow of new borrowing can be ignored, and the bond stock treated as exogenously fixed. With no new borrowing, the link from the interest rate is liked to the real economy because it is used to discount the expected flow of profits from new investment — not by business owners themselves, but by the stock market. It’s an oddly convoluted story.

4. A more general liquidity-preference story. Jorg Bibow, in a couple of his essential articles on the Keynesian theory of liquidity preference, suggests that many of the odd features of the theory are due to Keynes’ decision to drop the sophisticated analysis of the financial system from The Treatise on Money and replace it with an assumption of an exogenously fixed money stock. (It’s striking that banks play no role in in the General Theory.) But I’m not sure how much simpler this “simplification” actually makes the story, or whether it is even logically coherent; and in any case it’s clearly inapplicable to our modern world of bank-created credit money. In principle, it should be possible to tell a more general version of the liquidity preference story, where, instead of wealth holders balancing the income from holding a bond against the liquidity from holding “money,” you have banks balancing net income against incremental illiquidity from simultaneously extending a loan and creating a deposit. I’m afraid to say I haven’t read the Treatise, so I don’t know how much you can find that story there. In any case it doesn’t seem to have been developed systematically in later theories of endogenous money, which typically assume that the supply of credit is infinitely elastic except insofar as it’s limited by regulation.

5. The interest rate is set by the central bank. This is the orthodox story when we turn to the macro textbook. It’s also the story in most heterodox writers. From Wicksell onward, the whole discussion about interest rates in a macroeconomic context is about how the central bank can keep the interest rate at the level that keeps current expenditure at the appropriate level, and what happens if it fails to do so. It is sometimes suggested that the optimal or “natural” interest rate chosen by the central bank should be the the Walrasian intertemporal exchange rate — explicitly by Hayek, Friedman and sometimes by New Keynesians like Michael Woodford, and more cautiously by Wicksell. But the question of how the central bank sets the interest rate tends to drop out of view. Formally, Woodford has the central bank set the interest rate by giving it a monopoly on lending and borrowing. This hardly describes real economies, of course, but Woodford insists that it doesn’t matter since central banks could control the interest rate by standing ready to lend or borrow unlimited amounts at thresholds just above and below their target. The quite different procedures followed by real central banks are irrelevant. [1]

A variation of this (call it 5a) is where reserve requirements bind and the central bank sets the total quantity of bank credit or money. (In a world of bind reserve requirements, these will be equivalent.) In this case, the long rate is set by the demand for credit, given the policy-determined quantity. The interbank rate is then presumably bid up to the minimum spread banks are willing to lend at. In this setting causality runs from long rates to short rates, and short rates don’t really matter.

6. The interest rate is set by convention. This is Keynes’ other theory of the interest rate, also introduced in the General Theory but more fully developed in his 1937 article “Alternative Theories of the Rate of Interest.” The idea here is that changes in interest rates imply inverse changes in the price of outstanding bonds. So from the lenders’ point of view, the expected return on a loan includes not only the yield (as adjusted for default risk), but also the capital gain or loss that will result if interest rates change while the loan is still on their books. The longer the term of the loan, the larger these capital gains or losses will be. I’ve discussed this on the blog before and may come back to it in the future, but the essential point is that if people are very confident about the future value of long rates (or at least that they will not fall below some floor) then the current rate cannot get very far from that future expected rate, no matter what short rates are doing, because as the current long rate moves away from the expected long rate expected capital gains come to dominate the current yield. Take the extreme case of a perpetuity where market participants are sure that the rate will be 5% a year from now. Suppose the short rate is initially 5% also, and falls to 0. Then the rate on the perpetuity will fall to just under 4.8% and no lower, because at that rate the nearly 5% spread over the short rate just compensates market participants for the capital loss they expect when long rates return to their normal level. (Obviously, this is not consistent with rational expectations.) These kinds of self-stabilizing conventional expectations are the reason why, as Bibow puts it, “a liquidity trap … may arise at any level of interest.” A liquidity trap is an anti-bubble, if you like.

What do we think about these different stories?

I’m confident that the first story is wrong. There is no useful sense in which the interest rate on debt contracts — either as set by markets or as target by the central bank — is the price of goods today in terms of goods tomorrow. The attempt to understand interest rates in terms of the allocation across time of scarce means to alternative ends is a dead end. Some other intellectual baggage that should overboard with the “natural” rate of interest are the “real”rate of interest, the idea of consumption loans, and the intertemporal budget constraint.

But negative criticism of orthodoxy is too easy. The real work is to make a positive case for an alternative. I don’t see a satisfactory one here.

The second and third stories depend on the existence of “money” as a distinct asset with a measurable, exogenously fixed quantity. This might be a usable assumption in some historical contexts — or it might not — but it clearly does not describe modern financial systems. Woodford is right about that.

The fifth story is clearly right with respect short rates, or at least it was until recently. But it’s incomplete. As an empirical matter, it is true that interbank rates and similar short market rates closely follow the policy rate. The question is, why? The usual answer is that the central bank is the monopoly supplier of base money, and base money is used for settlement between banks. This may be so, but it doesn’t have to be. Plenty of financial systems have existed without central banks, and banks still managed to make payments to each other somehow. And where central banks exist, they don’t always have a monopoly on interbank settlement. During the 19th century, the primary tool of monetary policy at the Bank of England was the discount rate — the discount off of face value that the bank would pay for eligible securities (usually trade credit). But if the discount rate was too high — if the bank offered too little cash for securities — private banks would stop discounting securities at the central bank, and instead find some other bank that was willing to give them cash on more favorable terms. This was the problem of “making bank rate effective,” and it was a serious concern for 19th century central banks. If they tried to raise interest rates too high, they would “lose contact with the market” as banks simply went elsewhere for liquidity.

Obviously, this isn’t a problem today — when the Fed last raised policy rates in the mid-2000s, short market rates rose right along with it. Or more dramatically, Brazil’s central bank held nominal interest rates around 20 percent for nearly a decade, while inflation averaged around 8 percent. [2] In cases like these, the central bank evidently is able to keep short rates high by limiting the supply of reserves. But why in that case doesn’t the financial system develop private substitutes for reserves? Mervyn King blandly dismisses this question by saying that “it does not matter in principle whether the disequilibrium in the money market is an aggregate net shortage or a net surplus of funds—control of prices or quantities carries across irrespective of whether the central bank is the monopoly supplier or demander of its own liabilities.” [3] Clearly, the central bank cannot be both the monopoly supplier and the monopoly demander of reserves, at least not if it wants to have any effect on the rest of the world. The relevant question — to which King offers no answer — is why there are no private substitutes for central bank reserves. Is it simply a matter of legal restrictions on interbank settlements using any other asset? But then why has this one regulatory barrier remained impassable while banks have tunneled through so many others? Anyway, going forward the question may be moot if reserves remain abundant, as they will if the Fed does not shrink its balance sheet back to pre-crisis levels. In that case, new tools will be required to make the policy rate effective.

The sixth story is the one I’m most certain of. First, because it can be stated precisely in terms of asset market equilibrium. Second, because it is consistent with what we see historically. Long term interest rates are quite stable over very long periods. Third, it’s consistent with what market participants say: It’s easy to find bond market participants saying that some rate is “too low” and won’t continue, regardless of what the Fed might think. Last, but not least from my point of view, this view is clearly articulated by Keynes and by Post Keynesians like Bibow. But while I feel sure this is part of the story, it can’t be the whole story. First, because even if a conventional level of interest rates is self-stabilizing in the long run, there are clearly forces of supply and demand in credit markets that push long rates away from this level in the short run. This is even more true if what convention sets is less a level of interest rates, than a floor. And second, because Keynes also says clearly that conventions can change, and in particular that a central bank that holds short rates outside the range bond markets consider reasonable for long enough, will be able to change the definition of reasonable. So that brings us back to the question of how it is that central banks are able to set short rates.

I think the fundamental answer lies behind door number 4. I think there should be a way of describing interest rates as the price of liquidity, where liquidity refers to the capacity to honor one’s promises, and not just to some particular asset. In this sense, the scarce resource that interest is pricing is trust. And monetary policy then is at root indistinguishable from the lender of last resort function — both are aspects of the central bank’s role of standing in as guarantor for commitments within the financial system.  You can find elements of this view in the Keynesian literature, and in earlier writers going back to Thornton 200-plus years ago. But I haven’t seen it stated systematically in way that I find satisfactory.

UPDATE: For some reason I brought up the idea of the interest rate as the price of money without mentioning the classic statement of this view by Walter Bagehot. Bagehot uses the term “price of money” or “value of money” interchangeably with “discount rate” as synonyms for the interest rate. The discussion in chapter 5 of Lombard Street is worth quoting at length:

Many persons believe that the Bank of England has some peculiar power of fixing the value of money. They see that the Bank of England varies its minimum rate of discount from time to time, and that, more or less, all other banks follow its lead, and charge much as it charges; and they are puzzled why this should be. ‘Money,’ as economists teach, ‘is a commodity, and only a commodity;’ why then, it is asked, is its value fixed in so odd a way, and not the way in which the value of all other commodities is fixed? 

There is at bottom, however, no difficulty in the matter. The value of money is settled, like that of all other commodities, by supply and demand… A very considerable holder of an article may, for a time, vitally affect its value if he lay down the minimum price which he will take, and obstinately adhere to it. This is the way in which the value of money in Lombard Street is settled. The Bank of England used to be a predominant, and is still a most important, dealer in money. It lays down the least price at which alone it will dispose of its stock, and this, for the most part, enables other dealers to obtain that price, or something near it. … 

There is, therefore, no ground for believing, as is so common, that the value of money is settled by different causes than those which affect the value of other commodities, or that the Bank of England has any despotism in that matter. It has the power of a large holder of money, and no more. Even formerly, when its monetary powers were greater and its rivals weaker, it had no absolute control. It was simply a large corporate dealer, making bids and much influencing—though in no sense compelling—other dealers thereby. 

But though the value of money is not settled in an exceptional way, there is nevertheless a peculiarity about it, as there is about many articles. It is a commodity subject to great fluctuations of value, and those fluctuations are easily produced by a slight excess or a slight deficiency of quantity. Up to a certain point money is a necessity. If a merchant has acceptances to meet to-morrow, money he must and will find today at some price or other. And it is this urgent need of the whole body of merchants which runs up the value of money so wildly and to such a height in a great panic…. 

If money were all held by the owners of it, or by banks which did not pay an interest for it, the value of money might not fall so fast. … The possessors would be under no necessity to employ it all; they might employ part at a high rate rather than all at a low rate. But in Lombard Street money is very largely held by those who do pay an interest for it, and such persons must employ it all, or almost all, for they have much to pay out with one hand, and unless they receive much with the other they will be ruined. Such persons do not so much care what is the rate of interest at which they employ their money: they can reduce the interest they pay in proportion to that which they can make. The vital point to them is to employ it at some rate… 

The fluctuations in the value of money are therefore greater than those on the value of most other commodities. At times there is an excessive pressure to borrow it, and at times an excessive pressure to lend it, and so the price is forced up and down.

The relevant point in this context is the explicit statement that the interest, or discount, rate is set by the supply and demand for money. But there are a couple other noteworthy things. First, the concept of supply and demand is one of monopolistic competition, in which lenders are not price takers, but actively trade off markup against market share. And second, that the demand for money (i.e. credit) is highly inelastic because money is needed not only or mainly to purchase goods and services, but first and foremost to meet contractual money commitments.

[1] See Perry Mehrling’s useful review. Most of the text of Woodford’s textbook can be downloaded for free here. The introduction is nontechnical and is fascinating reading if you’re interested in this stuff.

[2] Which is sort of a problem for Noah Smith’s neo-Fisherite view.

[3] in the same speech, King observes that “During the 19th century, the Bank of England devoted considerable attention to making bank rate ‘effective’.” His implication is that central banks have always been able to control interest rates. But this is somewhat misleading, from my point of view: the Bank devoted so much attention to making its rate “effective” precisely because of the occasions when it failed to do so.